The Economics of the Public Sector
1. Externalities
1.1 Externalities and Market Inefficiency
The market failures examined in this chapter fall under a general category called externalities.
Externality: the uncompensated impact of one person’s actions on the well-being of a bystander (a person who sees sth. that is happening but is not involved)
positive / negative externality
Internalizing the externality: altering incentives so that people take into account the external effects of their actions
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Negative externalities lead markets to produce a larger quantity than is socially desirable.
- The government can internalize the externality by taxing goods that have negative externalities
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Positive externalities lead markets to produce a smaller quantity than is socially desirable.
- The government can and subsidizing goods that have positive externalities.
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Supply curve -> private & external cost
- Demand curve -> private and external benefit
1.2 Public Policies toward Externaties
- Command-and-Control Policies: Regulation
- Market-Based Policy 1: Corrective Taxes and Subsidies
- Market-Based Policy 2: Tradable Pollution Permits
1.3 Private Solutions to Externalities
The Coase Theorem: If private parties can bargain over the allocation of resources at no cost, then the private market will always solve the problem of externalities and allocate resources efficiently.
The Coase theorem says that private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient.
2. Public Goods and Common Resources
Excludability: the property of a good whereby a person can be prevented from using it
Rivalry in consumption: the property of a good whereby one person’s use diminishes other people’s use
Public goods and common resources have no price, not excludable, but have value. Markets may fail in allocating them.
2.1 Public Goods
Free rider: a person who receives the benefit of a good but avoids paying for it
- Because public goods are not excludable, the free-rider problem prevents the private market from supplying them.
- The government, however, can remedy the problem. If the government decides that the total benefits of a public good exceed its costs, it can provide the public good, pay for it with tax revenue, and potentially make everyone better off.
- However, it is hard to evaluate the benefits. Thus it is more difficult to provide efficient public goods than to provide private goods.
2.2 Common Resources
Examples: Clean air & water, oil, Congested Roads, ...
Tragedy of the Commons
Solutions:
- Regulation
- Corrective Taxes (internalized the externality by taxing sheep)
- Auctioned off a limited number of sheep-grazing permits
- Split and sell to families